Tuesday, June 19, 2007

In this very interesting speech, Malcom Knight, General Manager of the BIS, analyzes the situation of "ample growth in global liquidity and generalised compression of risk spreads". He reviews two hypotesis about the "recent benign conditions in financial markets": (a) monetary policy; (b) the global saving-investment imbalance and the related increase in foreign exchange reserves. The end-game is different in each case. If you believe that G7 monetary policy has been the driving force behind the global liquidity boom, then the end is nigh:

... if monetary policy has played a dominant role, the rise in inflation that has been observed recently in many countries and the likelihood of a further tightening of global monetary conditions suggest that the current episode of low interest rates and tight spreads could end quickly. This could have an adverse impact on interest rate sensitive sectors of the economy and lead to a withdrawal of liquidity from precisely those markets that have benefited the most from low interest rates.

By contrast, "saving-investment imbalances evolve slowly over time". In othe words: expect the observed changes in yields and spreads to be reversed only gradually. And this is precisely where things get interesting:

... a further prolonged period of low interest rates and tight spreads of the sort that is implied by the saving-investment hypothesis risks encouraging even more leveraging in the short to medium term. The further build-up of global foreign exchange reserves could have similar implications. This suggests that the current episode of ample liquidity may be longer, involve a continued build-up of positions, and have an even more uncertain resolution than one might at first have expected.

1 comment:

"may be longer, involve a continued build-up of positions, and have an even more uncertain resolution than one might at first have expected."

I agree with your emphasis on this final sentence. The liquidity bears are looking for an imminent "event" that will bring this liquidity cycle to a rapid end.

Most likely, only after most stop looking for such a definable event will the consequences of the end of the cycle become known. They will most likely be significant, but are unlikely to play out in the way that most imagine.